Tuesday, September 23, 2008

Wall Street Meritocracy is based on wrong accounting

From 2001 to 2006, national housing price rises more than 60%, according to Federal Reserve. In that kind of environment, sub-prime borrowers don't go bust. If they can not pay the mortgage, they will sell the house at a higher price and repay the loan in full. Mortgage lender and Wall Street firms are hugely profitable because they can lend at a high interest rate to sub-prime borrowers and yet enjoy a low default rate similar to that of investment grade. And the executives enjoy compensation linked to these huge profits. That is until the housing price starts to fall. Mortgage losses pile up and the assets based on these mortgage worth only a fraction of that in the good times. Write offs amount to hundreds of billions of dollars and investor's worth plunged.

Business will always have cycles. In good times the profit is overstated. Inflated housing price is sure to fall at some point. But Wall Street compensation never factors in this fact. If they are rewarded for the good times, it is only fair that they suffer at the bad times. When investors see huge losses in their pension portfolio, Wall Street executive don't get negative number of compensation.

My conclusion: Wall Street executives are not compensated according to performance. They are having a call option on business cycles: hugely rewarded at good times and immune from bad times. Is this meritocracy? Is this pay for performance? Or is it just ripping benefits of economic growth while avoiding the unavoidable slumps? At a minimum we should not call such lopsided compensation meritocracy. It is based on incorrect accounting.